Final answer:
The rational decision in this case would be to pay off the debt, but many people tend to prioritize short-term gains over long-term benefits. Behavioral economics provides insights into why people exhibit this irrational behavior and recommends strategies to promote more rational saving decisions.
Step-by-step explanation:
The "rational" decision would be to pay off the debt, since a $1,000 savings account with $0 in debt is the equivalent net worth, and she would now net $20 per year. Curiously, it is not uncommon for people to ignore this advice, since they will treat a loss to their savings account as higher than the benefit of paying off their credit card. They do not treat the dollars as fungible so it looks irrational to traditional economists.
Behavioral economics provides insights into why people are bad at savings, and what we can do about it. For example, when employees have to opt-in to their retirement savings (making the default zero) they are less likely to save for retirement than if they had to opt out of savings instead. Although the default should not matter for savers' decisions, it does, and it matters a lot. In an experiment based on switching workers to automatic enrollment, 86% of employees contributed to a 401(k) plan when enrollment was automatic, but just 49% participated when they had to opt-in.
Traditional economists also assume human beings have complete self-control but people often engage in irrational behavior when it comes to savings. They may prioritize short-term gains over long-term benefits, such as treating a loss to their savings account as more significant than paying off their credit card debt. Additionally, people often struggle with self-control and may procrastinate or feel overwhelmed when it comes to making saving decisions. Behavioral economists propose strategies, such as automatic enrollment in retirement savings plans, to help individuals make more rational savings choices.